One of the investment mantras we constantly hear about is the need for us as investors to be patient and think long-term. Whilst many of us know this principle, few really follow it in real life – it is akin to the statement of eating well and exercising more. But in this post today I will explain why patience is essential to earning above average returns. I will try to approach it based on logic and not because the gurus of investing have been preaching it.
In order to understand the importance of being patience, let’s take a series of logical steps:
- Research by way of the Efficient Market Hypothesis has shown the stock market to be usually efficient meaning that most companies share prices are valued correctly based on their near term prospects. So if a company is growing at 20% per annum, earning 15% return on capital and has great long term growth prospects, then the market will value it accordingly.
- Following on from the above, if you want to do better than the market, you need to have a view about the performance of a company which differs materially from that of the markets. So if the company produces results that are in line with expectations (what the market expects), there shouldn’t be an impact on the stock price. Only if a company performs better than market expectations, will the stock price adjust upwards in response to the positive ‘surprise’. This is something most investor miss. They are looking for high quality companies with good management. The trick for outperformance is to find those where the market has yet to recognise the quality or improvement in performance (and price it into the stock)
- Combining the two points mentioned above, you as an investor are able to produce market beating returns if:
- You are able to identify the turning point in a cyclical industry, before the market. As it not usually not possible to time this perfectly, the best option is to be a bit early when there are some green shoots visible and then increase the position as the recovery gathers strength.
- Some one off event such as a de-merger causes one of the constituents to be mis-priced. You often see that the share price of the company that has been spun off follows a downtrend in the months after the spin-off due to investors putting downward pressure by selling their positions.
- The profits of the company are suppressed due to some short term issues in the industry which will be resolved soon. In such cases, one has to create a position when the outlook is still horrible and hold on to it till the external factors change for the better. The money is made here when things go from bad to less bad. Just look at commodity stocks at the beginning of 2016 for an example of this.
- The profit of the company is suppressed as management is investing in the business which is hurting the reported numbers. As the market is still fixated on the reported numbers, one can create a position at an attractive price. However one has to wait for the investment phase to complete and the true profitability surface.
Looking at the above points, it is clear that if you want market beating returns, you will need to ignore the near term prospects which are being overly discounted by the market, and focus on the long term. You also need to understand that due to the markets short term thinking on a particular company, you will probably not see a validation of your thesis as soon as you create a position. The stock you purchase is likely to keep going down due to market forces and this is why you need to have a long term holding period. In my experience, one needs to look out at least 3-4 years ahead when making a purchase. One then has to wait patiently and keep checking if the company continues to deliver as per your expectations
As an individual investor, the Time Horizon Advantage is our greatest weapon. Whilst most institutional and professional investors need to produce returns on a quarterly basis or face outflows, we as individuals can think long term and buy stocks that look ugly today but turn into swans tomorrow.
A good example of using Long Term thinking to my advantage is when I bought shares in Royal Dutch Shell. Most institutional investors were scared about the falling oil price and the subsequent short term impact it would have on the oil majors such as Royal Dutch Shell. As such, many professionals were selling Royal Dutch Shell stock hand over fist as they were only interested in the next quarters results as opposed to the next years results. The share prices of Royal Dutch Shell fell so hard that the company now had a dividend yield of 10% – and remember this was a company that had not cut its dividend since World War 2. As such, it was a no brainer for an average investor like myself to back up the truck and sink a good chunk of my money into Royal Dutch Shell stock. Sure, once I made my purchase the share price continued to drop but I was not in it for the short-term. It is now 18 months since my purchase of Shell shares and I am up almost 70%! Thinking long-term does pay off!